We aren't aware of any words that are used in as many varying and confusing
ways as the words inflation and deflation. When the word inflation is used
by a journalist or analyst, for example, it often means a increase in the general
level of consumer prices, but it could also mean an increase in asset prices
or an increase in the supply of money. However, it is very important to settle
on a definition that makes sense and to then apply the definition consistently
in the analysis of all things financial/economic because the failure to do
so leads to huge errors.

When we talk about inflation at TSI we are referring to an increase in the
total supply of money and credit, not a rise in the general price level; and
when we use the word deflation at TSI we mean a contraction in the total supply
of money and credit, not a fall in the general price level**. Inflation and
deflation CAUSE prices to change, but not all price changes are EFFECTS of
inflation and deflation. Which brings us to the main reason why it is important
to define the terms consistently and correctly: defining inflation and deflation
in terms of price changes fails to distinguish between cause and effect.

As a hypothetical example of how mixing-up cause and effect can create a big
problem consider the case of the doctor who couldn't, or who didn't think it
was important to, distinguish between a pain in the chest caused by heart disease
and one caused by indigestion. A pain in the chest can have many different
causes with very different consequences as far as the patient's longer-term
well-being and required treatments are concerned, so our hypothetical doctor's
inability or unwillingness to differentiate between the various possible causes
of the pain could have catastrophic results for the patient. A financial market
analyst or economist who can't, or doesn't think it is important to, distinguish
between price changes caused by inflation/deflation and price changes caused
by other factors is making a similar mistake, although unlike the doctor the
financial analyst is not running the risk of being sued for mal-practice as
a result of his/her mistake.

In addition to the mixing-up of symptom and disease (effect and cause), there
is the issue -- an issue that will likely be overlooked by those who think
inflation is an increase in prices -- that during the early and middle stages
of an inflation cycle some prices will FALL. In fact, Ludwig von Mises and
other great economists of the Austrian School have explained that this particular
characteristic of inflation -- the way it affects prices in a non-uniform manner
-- is what gives it great appeal to the financial and political elite. After
all, if a 10% increase in the money supply immediately pushed all prices higher
by 10% then nobody would have the opportunity of benefiting from the inflation.
The way it actually works, though, is that the prices of some things will rise
earlier and faster than the prices of other things, thus allowing some people
to profit from the inflation before others become aware of what is going on.
Inflation is, in actuality, a surreptitious means of wealth distribution.

Another problem faced by those who insist on defining inflation/deflation
in terms of price changes is that they are effectively pulling the wool over
their own eyes. For example, take the case where a) the money supply is growing
at a rapid rate, b) the year-over-year increase in consumer prices is zero,
and c) labour productivity is growing at a 5% clip. In this situation the definition-challenged
analyst will proclaim that there's no inflation, but prices should have FALLEN
by around 5% due to the productivity growth. In other words, in this case there
was enough inflation to offset any benefit that the 'man on the street' would
have otherwise received as a result of the increase in his productivity.

A related problem to the one just mentioned is that any analyst/economist/commentator
who defines inflation and deflation in terms of price changes is unwittingly
helping the central bank to manage inflation expectations by keeping the public
in the dark. Inflating the supply of money, you see, is not a major challenge
for the central bank under the type of monetary system we have today, but keeping
inflation expectations low can be an enormous challenge at times. One method
that is used to keep inflation expectations in check is to calculate the widely-watched
price indices in ways that substantially understate the true effects of inflation,
but going to the trouble of manufacturing artificially-low price indices is
not useful unless almost everyone believes inflation to be an increase in the
general price level. Furthermore, if most people believe that falling prices
somewhere in the economy represent deflation, or a 'deflationary threat', then
whenever prices fall the monetary authorities immediately have the justification
to promote more inflation. This concept is very relevant right now because,
as warned at TSI over the past several months, there will probably be a "deflation
scare" during 2005-2006 as a result of falling commodity and stock prices.
This 'scare' will, in turn, set the scene for the next big wave of central-bank-sponsored
inflation, but the whole charade is only made possible because most of the
people whose job it is to report on the financial markets and the economy are
clueless when it comes to the true meanings of inflation and deflation. In
effect, the inability or unwillingness of most analysts to define inflation
and deflation correctly enables the engines of inflation (the Fed and other
central banks) to masquerade as inflation fighters. Refer to http://www.mises.org/story/908 for
additional discussion on this issue.

OK, so there are some very good reasons to differentiate between inflation/deflation
(the cause) and price changes (the effect). Can we, though, avoid the confusion
by describing changes in the money supply as "monetary inflation" or "monetary
deflation" and changes in the general price level as "price inflation" or "price
deflation"? The answer is no, because if you do this you are using the words
inflation/deflation to mean one thing one minute and another thing the next. "Monetary
inflation", for example, would mean MORE money whereas "price inflation" would
mean HIGHER prices. Also, if you do this you will, in many instances, be associating
the words inflation and deflation with price changes that have absolutely nothing
to do with inflation or deflation. That is, you will be adding to the general
confusion.

In conclusion, getting the definitions of inflation and deflation right paves
the way to a better understanding of what is really happening in the financial
world. There's simply no need to make an inexact science (economics) even more
inexact by using nonsensical, inconsistent, and downright misleading definitions.

**A more technically correct definition of inflation would be an increase
in the supply of money that causes the general price level to rise, and a
more technically correct definition of deflation would be a decrease in the
supply of money that causes prices to fall. However, we think these definitions
add an unnecessary layer of complexity because:

a) It is very difficult, perhaps even impossible, to measure the change
in the general price level with accuracy
b) The effects of inflation are sometimes seen mostly in financial-asset prices
whereas at other times they are seen in commodity and consumer prices
c) It is extremely unlikely that there would ever be a substantial increase
in the supply of money that did not eventually lead to higher prices somewhere
in the economy or a substantial decrease in the supply of money that did not
eventually lead to lower prices.

In any case, the important thing to understand is that a price increase
cannot possibly be related to inflation unless it was preceded by an increase
in the money supply and a price decrease cannot possibly be related to deflation
unless it was preceded by a decrease in the money supply.